Generally, payment system is exposed to three types of financial risks
viz., liquidity risk, credit risk and systemic risk.
Liquidity Risk
Liquidity risk refers to inability of counterparty to honour payment
obligation(s) in time, either due to cash flow short fall or insufficient
funds. Technically, it can be termed as failed transaction rather than a
default. In this case, counterparty might settle full value at a later
date/time. However, when settlement failure takes place it is not easy
to determine whether it is a default or failure. This results in loss of
confidence in the counterparty that failed, which could cause its
counterparties to withhold settlement for other transactions. This in
turn could accentuate the liquidity problem. Further, in order to cover
cash flow short fall, payee may turn to expensive borrowings or
liquidation of assets.
Credit Risk
Credit risk refers to default in payment or obligation for full value. It
includes both "replacement cost risk" where there is loss of unrealised
gains on unsettled contracts with the defaulting participant and
"principal risk" that is, risk of loss of the full value of funds.
Competing claims of credit losses are generally settled through third
party adjudication and takes time.
Systemic Risk
Systemic risk results from settlement failure of one or more
participants in the payment system leading to liquidity and solvency
problems for other participants. Such a failure could trigger a chain
reaction resulting in general financial failure and even jeopardising the
real economy. The risk potential is higher in large value transfer
system than small value transfer systems, because high value
transactions results in higher exposure to risk.
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Sources of Payment Risk
Major sources of above mentioned risks are settlement lag and
asynchronous payment. Settlement lag refers to a time lag between
the execution of the transaction and its final completion, wherein
there is lag between initiation of payment message and the final
settlement of the payment.
Asynchronous settlement occurs where there is a time lag between
payment leg and delivery leg of the transaction, i.e., where buyer
makes payment but would not receive an asset (money, foreign
exchange, securities or other financial instruments) and/or seller
makes delivery of an asset but does not receive payment.
Thus, a sound payment system should incorporate norms and
procedures:-
a) which reduce transactions arising out of settlement failure and
b) Insulate payment system as a whole from failed individual
participants.
